Financial innovation / tax sheltersFinancial innovation / tax sheltersand the income tax systemand the income tax system

PUBPOL 744 | Taro Nagao | Apr 16, 2007PUBPOL 744 | Taro Nagao | Apr 16, 2007

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Agenda

• Realization Doctrine: Review

• Current income tax treatments on financial products

• Financial innovation (“put-call parity”) and its implication to the income tax policy

• Policy options on financial innovations

• Tax shelters and corporate tax avoidance

• Policy options on tax shelters

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Realization Doctrine: Review

• Haig-Simons Definition: Income = Consumption + "Net Increase in Wealth"

• Taxation on "Net Increase in Wealth" involves several problems - notably valuation and liquidity

• Therefore, Realization Doctrine is implemented in practice, where

• Taxes are paid at the time the asset is sold

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Taxation on financial products

• Traditionally two types of tax treatments

• Relied on a distinction between "fixed" and "contingent" returns to determine when income is taxed

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1) Fixed-return instruments

• Example: Bonds

• Characteristic: Return is known when purchased

• Tax treatment: Taxable amount is calculated annually on a yield-to-maturity basis

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Example

• Zero coupon bond, issued at $100, pay $133 in three years

• Yield to Maturity = 10%

• Taxable income: $10 is included in Year 1, $11 in Year 2, and $12 in Year 3

$10 $11Taxable Amount: $12

$100

$133

1 20 3

0 0Cash Income: $33

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1) Fixed-return instruments

• Example: Bonds• Characteristic: Return is known when

purchased• Tax treatment: Taxable amount is

calculated annually on a yield-to-maturity basis

• Rationale: The asset value will increase to a known amount, so yield-to-maturity is a financially reasonable way to distribute that income over time

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2) Contingent-return instruments

• Example: Stocks, derivative products (forwards/futures, options)

• Characteristics: Return is unknown when purchased

• Tax treatment: Taxation is deferred until sale ("wait-and-see" approach)

• Rationale: At purchase, you never know whether there is any gain or loss after certain period of time

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Summary So Far

• There are two basic types of tax treatment on financial instruments

• Relied on a distinction of characteristics (“fixed” vs. “contingent” return)

• The distinction works only if the two categories of assets are clearly distinguished and not interchangeable

• In fact, they are easily interchangeable!

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Financial Equivalences

• Financial equivalences sometimes permit one category of asset to be replicated using the other

• One example: Put-call parity theorem

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Put-Call Parity Theorem

• Call Option: The right to buy an asset for a certain price in the future

• Put Option: The right to sell an asset for a certain price in the future

• Difference between stocks and options = options have “optionality”

• If you own an option and the market moves unfavorably, you do not incur any loss

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Payoff($)

Future Stock Price ($)

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Payoff from stocksPayoff($)

Future Stock Price ($)

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Payoff from bondsPayoff($)

Future Stock Price ($)

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Payoff from call options

X

Payoff($)

Future Stock Price ($)

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Payoff from put options

X

Payoff($)

Future Stock Price ($)

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How do you get this payoff?Payoff($)

There are two ways:

• Buy Bond & Call Option

• Buy Stock & Put Option

Future Stock Price ($)

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Put-Call Parity Theorem

• Stock + Put Option = Bond + Call Option

Or,• Bond = Stock + Put Option - Call Option

(fixed) (contingent) (contingent) (contingent)

• If you own a bond but do not like its tax treatment,• You can replace the bond with a stock, a put

option and a short call option• This undermines the income tax distinction

between fixed and contingent return assets

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Summary So Far

• Modern financial theory has identified certain equivalences (e.g. Put-call parity) that allow different types of assets to be reconstructed in terms of each other

• Implication for income tax policy: these equivalences would undermine the fundamental distinction between assets that are treated differently for tax purposes

• There are many types of distinctions that can be undermined by financial innovations:– Character (ordinary income or capital gain)– Source (domestic or foreign)

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Policy options on financial innovations (Warren, 2002)1) Transactional analysis

2) Taxation of changes in market value

3) Formulaic taxation

4) Anti-avoidance provisions

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1) Transactional analysis

• Analyze components of a new transaction in order to achieve consistent treatment with other, more familiar assets

• Example: convertible bond = bond & option to buy stock

• Pros:– Make economic sense

• Cons: – Reactive and ad hoc– “Repeated game”: taxpayers always find new loopholes– Make tax system complicated: away from the Haig-Sim

ons ideal

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2) Mark-to-market taxation

• Directly measure "Net Increase in Wealth"

• Pros:– In line with Haig-Simons ideal

• Cons:– Valuation – Liquidity

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3) Formulaic Taxation

• Apply certain formulas/methods to compute tax• Examples:

– Retrospective taxation– Generalized cash-flow taxation

• Pros:– Achieve (or move toward) Haig-Simons ideal without

measuring “Net Increase in Wealth”

• Cons:– GCFT: Different tax rate must be computed for each p

erson every year based on his/her age

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4) Anti-avoidance provisions

• Disallow tax benefits in certain "tax-sheltering" transactions

• Need to define “tax-sheltering transaction”

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Summary So Far

• Tax system must be redesigned in response to financial innovations

• Four policy options are presented in Warren (2002):– Transactional analysis– Taxation of changes in market value– Formulaic taxation– Anti-avoidance provisions

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Tax Shelter Problem (Bankman, 2004)• Definition: Tax shelter is best defined as

– (1) tax motivated– (2) transaction unrelated to a taxpayer's normal

business operations– (3) under a literal reading of some relevant legal

authority– (4) produces a loss for tax purposes in excess of any

economic loss– (5) in a manner inconsistent with legislative intent or

purpose

• Example: "Short sales against the box"

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Tax shelter: Government weapons

• Amend the regulation upon which the shelter is based– Reactive and ad hoc– Taxpayers always find new loopholes– Complicated tax regulations

• Economic Substance Doctrine

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Economic Substance Doctrine

• Even a transaction that otherwise complies with a governing statute can be disregarded for tax purposes if it lacks significant non-tax motive or effect

• Provide speed/flexibility to government• No predictability for taxpayers

– What kind of transactions have “non-tax motive”?

– How much substance must a transaction have?

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Economic Substance Doctrine – in practice• Economic substance doctrine was almost

uniformly upheld by courts, and the government won almost every case it brought against shelters

However,

• The government did not have good success in finding shelters that were hidden in complex corporate returns

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Policy options on tax shelters (Bankman, 2004)• Increase tax-book conformity; corporate taxpayers

claiming tax losses were forced to recognize losses for financial accounting purposes

• Amend and replace economic substance doctrine with statutes based on newly-drawn definitions

• Raise the ex-ante cost of shelter by increasing penalties (short-term)

• Structural reform; Pure cash flow-based taxation (long-term)